Thursday, May 21, 2009

A new global system is coming into existence

The following is an interesting article that was published in The Economist magazine. I present a critique of its argument in this post. Note that the italized sections of this missive represent The Economist's words, while the bold sections represent my refutations.


ALL monetary and economic systems are a struggle between borrowers, who favour inflation, and creditors, who are determined to maintain the purchasing power of the currency. In a democracy, this is a very fluid battle. The creditors have the money and therefore the ear of the political elite; the borrowers tend to have the votes.

[If an economic system is based on respect for the law in the form of property rights, sound money, and voluntary exchange there is no “struggle” to speak of. The “struggle” arises when perverse incentives get in the way by intervening in the market by government or a government-sponsored agency. ]

Creditors have periodically imposed monetary anchors in an attempt to defeat the borrowers’ lobby. These anchors are devised in prosperous times but run into difficulty during recessions. The gold standard failed to outlast the Depression. For nations with a shortage of gold, the “right” thing to do was to raise interest rates in an attempt to lure gold back; the austerity this imposed on the rest of the economy was politically unacceptable.

[One can write volumes expanding what the author has just claimed. Let’s speak in non-politically correct language. Creditors want sound money, borrowers do not. Creditors hate inflation, borrowers love inflation. The gold standard fomented sound money; as a consequence there was significant price stability. Given man’s unlimited wants, he will borrow if allowed without much hindrance. Too much borrowing always occurs. Borrowers can quickly gather to seek political favors: “I’ll give you my vote if you inflate.” The politician’s answer: “We need to get rid of the gold standard because it doesn’t permit me to inflate.” The borrower than says: “I’ll give you my vote if you inflate.” The politician then answers: “I will serve my constituents,”—which is another way of saying, “I want power.”]

The Bretton Woods era replaced a gold standard with a dollar standard (albeit with the American currency theoretically linked to bullion). The system worked well for more than two decades, helped by the post-war economic boom, particularly in Germany and Japan which began the period with undervalued exchange rates. It broke down because America refused to pay the domestic price for bearing the system’s weight.

[True. All empires extract some form of tribute from its territories. The American one did it in a peculiar manner. While previous empires levied tax money to flow from its conquered regions, the U.S. uses the inflation tax to get the same results. The U.S. dollar was inflated (i.e. print more than gold reserves allowed). The fact that the U.S. dollar is the world reserve currency gives the country special privileges (or as economist like to say, a free ride). The U.S. dollar free ride will continue until foreigners say “no mas.”]

When Bretton Woods failed, it was not immediately obvious what would replace it. European nations, in particular, maintained a hankering for fixed exchange rates. But floating rates eventually prevailed, particularly for the major currencies of the dollar, yen and D-mark.

The problem for creditors was that the floating-rate system was based on fiat (paper) money. What would keep the inflationary instincts of governments in check? The answer took a couple of decades (and recessions) to hammer out.

[Actually, what kept the inflationary instincts of governments in check was faith, or in economist-speak, managed expectations.]

Once it was accepted that the markets could set exchange rates, there was no real need for capital controls. And once capital could flow freely, ill-disciplined governments could be punished by higher bond yields. Politicians accordingly tried to reassure the markets by giving greater power to central banks, some of which set explicit inflation targets.

[During this time, the perception was given that central banks were “independent.” Of course, it was silly that market participants in fact believed this. There was never such a thing as central bank independence. Consider the Federal Reserve in its current standing: it does the dirty work of the Executive Office.]

The post-Bretton Woods system worked well, engendering the long period of low inflation and steady growth known as the Great Moderation. But one of the reasons for its apparent success—the growth of India and China—may have sparked its demise. The addition of these two great nations to the international financial system was a supply shock that put downward pressure on inflation rates.

[I would add the inclusion of formerly communist countries into the global financial system as a further supply shock. Moreover, financial innovation and technological improvement helped in this process too.]

As Stephen King, an economist at HSBC, has pointed out, the result might have been a benign deflation that boosted Western living standards. But central banks struggled to avoid a deflationary outcome; the result was a loose monetary policy that encouraged asset bubbles. Those bubbles lasted longer than expected because the flood of savings from developing markets held down the risk-free rate.

[It is absolutely true that central banks engaged in loose monetary policy, however some of the “savings from developing markets” was actually money printed out of thin air. The fact that the risk-free rate was below the one that would exist in the absence of manipulation caused all forms of capital misallocation. The present crisis is the result of central banking.]

Now it seems to be recognised that inflation targeting is not enough. Given the explicit government guarantee behind the banking system, central banks need to monitor both financial stability and asset prices. At the same time, some central banks have adopted (via quantitative easing) a policy of creating money to boost markets that also has the convenient side-effect of funding budget deficits. That is just what opponents of fiat money feared would happen in the long run.

[As I said previously, the idea that there was ever such a thing as central bank independence was silly.]

The same old dilemma will eventually occur. Having spent a fortune bailing out their banks, Western governments will have to pay a price in terms of higher taxes to meet the interest on that debt. In the case of countries (like Britain and America) that have trade as well as budget deficits, those higher taxes will be needed to meet the claims of foreign creditors. Given the political implications of such austerity, the temptation will be to default by stealth, by letting their currencies depreciate. Investors are increasingly alive to this danger; ten-year Treasury bond yields are around a percentage point higher than they were at the start of the year.

[Translation: Defaults via mass inflation. In other words, this type of default on debt will occur by way of printing money (which already has been) out of thin air to pay back what is owed. There will be a heavy tax, but it will be in the form of high inflation.]

Creditor nations tend to set the rules and the new global monetary system will be unable to operate without the approval of China, a creditor country that has capital controls and a managed currency. It has been assumed that China will have to move towards the Western model. But why not the other way round? Western countries adopted free capital markets, as the British adopted free trade in the 19th century, because it suited them. Will China now be able to call the shots? Uncomfortable as it might be for the West, the next monetary order is more likely to be made in Beijing than in New Hampshire.

[China will loose a lot of wealth in the coming mass inflation. They will gladly incur the cost if it leads them to call the shots in shaping the new economic and financial world order which will emerge after the crisis.]

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